Profitability and Return on Investment

Investments are made for two primary reasons:
- Earnings
- Capital Appreciation
Investors evaluate potential investments based on:
1. Profitability
2. Return on Investment (ROI)
3. Payouts: dividends and share buybacks
Various ratios are developed to assess these factors.
Context and trends are critical for proper interpretation of financial information analysis (FIA).

Profits are essential for the long-term viability of a business.
Different measures of profit are used to focus on distinct aspects:
- Gross Profit Rate (Gross Margin)
- Formula:
  $\text{Gross Profit Rate} = \left(\frac{\text{Gross Profit}}{\text{Revenue}}\right) \times 100\%$
- Example Calculation:
  $\text{Gross Profit Rate} = \left(\frac{4,849}{68,187}\right) \times 100\% = 7.11\%$
- Operating Profit Rate (Operating Margin)
- Formula:
  $\text{Operating Profit Rate} = \left(\frac{\text{Operating Profit}}{\text{Revenue}}\right) \times 100\%$
- Example Calculation:
  $\text{Operating Profit Rate} = \left(\frac{2,821}{68,187}\right) \times 100\% = 4.14\%$
Net Profit Rate
- Formula:
  $\text{Net Profit Rate} = \left(\frac{\text{Net Profit Before Tax}}{\text{Revenue}}\right) \times 100\%$
- Example Calculation:
  $\text{Net Profit Rate} = \left(\frac{2,289}{68,187}\right) \times 100\% = 3.36\%$
Operating/EBIT/PBIT/Net Overlap
- The terms EBIT (Earnings Before Interest and Taxes) and PBIT are consistent with IFRS 18 requirements.
EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization)
- Formula:
  $\text{EBITDA Rate} = \left(\frac{\text{EBITDA}}{\text{Revenue}}\right) \times 100\%$
- Example Calculation:
  $\text{EBITDA Rate} = \left(\frac{4,362}{68,187}\right) \times 100\% = 6.4\%$
- Note: See Tesco Annual Report for calculation details on EBITDA (p.223).

Return on Capital Employed (ROCE)
- Indicates the relationship between investment and earnings.
- Requirement: The numerator (Earnings) must be consistent with the denominator (Investment).
- Formula:
  $\text{ROCE} = \left(\frac{\text{PBIT (Operating Profit)}}{\text{Capital Employed}}\right) \times 100\%$
- Definition:
- Capital Employed = Equity + Long-term Debt
- Example Calculation:
  $\text{ROCE} = \left(\frac{2,821}{11,665 + 9,764}\right) = 13.2\%$
Return on Equity (ROE)
- This ratio focuses on the return enjoyed by shareholders.
- The denominator is Equity (Shareholder Funds) while the numerator reflects profit after interest, tax, and preference dividends.
- Formula:
  $\text{ROE} = \left(\frac{\text{Profit After Interest, Tax, and Preference Dividends}}{\text{Equity}}\right) \times 100\%$
- Example Calculation:
- Use profit from continuing operations as equity beneficiaries.
  $\text{ROE} = \left(\frac{1,764}{11,665}\right) \times 100\% = 15.1\%$

EPS is a widely utilized and closely regulated financial metric.
Formula:
$\text{EPS} = \frac{\text{Earnings}}{\text{Equity Shares in Issue}}$
According to IAS 33, EPS is categorized into Basic and Diluted EPS:
- Diluted EPS is calculated after considering stock options.
EPS must be presented at the end of the Statement of Profit or Loss with working notes.
Reported figures:
- Basic EPS: 24.8p
- Diluted EPS: 24.53p
Calculation complexities arise due to factors such as:
- New issues of shares
- Share options granted to employees

Price/Earnings Ratio (P/E Ratio)
- Explores the relationship between earnings and market price, serving as a measure of valuation in the investment community.
- Important benchmark; industry averages are often available for comparison.
- Formula:
  $\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}}$
- Example Calculation:
  $\text{P/E Ratio} = \frac{279p}{24.53p} = 11.4$
Earnings Yield
- Inverts the P/E Ratio to reflect returns generated in relation to the market price.
- Formula:
  $\text{Earnings Yield} = \frac{\text{EPS}}{\text{Market Price per Share}}$
Importance of P/E Ratio for Investors:
- A higher P/E Ratio indicates expectations of future EPS growth.
- P/E Growth index assesses relative growth expectations.
- Formula:
  $\text{P/E Growth} = \frac{\text{P/E}}{\text{Prospective growth in EPS}}$
- Prospective growth is based on assumptions and market movements.

Investors are typically looking to earn a return on their investments.
Total Shareholder Return (TSR)
- Formula:
  $\text{TSR} = \text{Share Price Appreciation} + \text{Dividends}$
Increasingly, companies participate in Share Buybacks:
- This involves companies repurchasing their shares from the market to return cash to shareholders.
- Benefits both the shareholder and the company, occasionally used to improve financial ratios.
- Attractive option for companies with surplus cash.

The dividend policy of a company is influenced by:
- Previous dividend policies
- Market expectations
- Availability of profits and cash reserves
Dividend Yield
- Formula:
  $\text{Dividend Yield} = \left(\frac{\text{Dividend per Share}}{\text{Market Price per Share}}\right) \times 100\%$
- Example Calculation:
  $\text{Dividend Yield} = \left(\frac{12.10p}{279p}\right) \times 100\% = 4.3\%$
Dividend Cover
- Formula:
  $\text{Dividend Cover} = \frac{\text{Profit After Tax and Pref Dividend}}{\text{Ordinary Dividend}}$
- Example Calculation:
  $\text{Dividend Cover} = \frac{1,764}{852} = 2.07 \text{ times}$
Dividend Payout
- Reflects the portion of profit paid out as dividends.
- Formula:
  $\text{Dividend Payout} = \frac{\text{Ordinary Dividend}}{\text{Profit after Tax less Pref Dividend}}$
- Example Calculation:
  $\text{Dividend Payout} = \frac{852}{1,764} = 0.48 \text{ times}$

Share buybacks are significant for both companies and shareholders.
- Shareholders receive an immediate cash return.
- Reduction in the number of shares outstanding can improve financial ratios.
Companies necessitate large cash reserves for buybacks, indicating limited investment alternatives or management limitations.
Share buybacks should be strategically balanced with capital expenditure (CAPEX).
- Price/Book (P/B) Ratio can be useful in analysis.
- Stock Market Valuation:
  $\text{Net Assets} = \frac{19,110}{11,665} = 1.64 : 1$

Businesses are compelled to generate returns through:
- Profits
- Capital Appreciation
Various ratios are developed to assess earnings and the returns associated with investments.
Profitability Ratios measure how successfully a firm generates profits.
Earnings Ratios evaluate firm performance from the investors' perspective.
Return on Equity (ROE) will be revisited in Chapter 17.